Why a weaker yen is not driving up prices: Goldman

Conventional wisdom that a weaker yen would drive up prices in Japan across the board doesn't hold, Goldman Sachs says, as cheaper oil undercuts price pressure.

"Downward pressure on inflation from cheaper crude oil will grow more pronounced and could reach close to -0.8 percentage point mid-way through the year," Goldman Sachs senior economist Tomohiro Ota said in a note published on Friday. Crude oil prices have declined around 50 percent since last June amid a global supply glut.

"Meanwhile, we expect the inflationary pressure of yen depreciation to be only 0.4 percentage points or so at most," Ota said, because currency rates have a diminishing impact on prices.

Ending two decades of deflation is one of the key pillars of Prime Minister Shinzo Abe's economic policies and the Bank of Japan's (BOJ) mandate. But they have fallen short thus far; in February, Japan's core inflation rate came in at around zero percent on-year, excluding the effect of the consumption tax hike in April 2014, government data released on Friday showed.

Tax hike bites

Japanese households have kept their purses closed since the government raised the consumption tax to eight percent from five percent in April 2014.

In February, household spending contracted by 2.9 percent on year – the 13th straight month of contraction. But given that imports account for just 20 percent of Japanese household spending, the tax hike may be having a wider negative impact than previously thought.

"The deterioration in fundamentals due to the consumption tax hike may be even worse than the BOJ envisioned," Ota said.

This in turn has led Japanese producers that use imported goods to pass higher import costs on by means other than raising prices, further undercutting inflation.

Food companies that use imported ingredients, for instance, are reducing package sizes or "mixing in cheaper materials", according to Goldman.

Only frontloading

That points to another worrying trend: initial price increases following the Bank of Japan's first quantitative easing efforts in 2013 were largely driven by external factors including rising oil prices and Japanese household frontloading big ticket purchases ahead of the consumption tax hike.

The yen's near 30 percent depreciation against the U.S. dollar and the more than 8 percent increase in oil prices between September 2012 and May 2014 boosted inflation in the second half of 2013 by around 0.5 percentage points, according to the Goldman report.

"Inflation at that time was effectively being underpinned solely by external factors," said Ota, noting that as the yen continues to depreciate, the impact on inflation has become limited.

The Japanese currency has weakened nearly 10 percent since the BOJ expanded its quantitative easing program at the end of October 2014, but that only lifted the inflation rate by 0.25 percentage points, the report said.

And that's unlikely to change going forward.

Even if the yen were to weaken to 150 per dollar, inflation would only rise "by 0.5 percent or so," and would not offset the deflationary pressure of oil, which has dropped by more than 50 percent since last July, Goldman said.

More easing?

With its two-year target to reach the two percent inflation by this April out of reach, analysts expect the BOJ to extend its goal and possibly ease monetary policy again.

Goldman for its part reckons the BOJ "will need to ease to preserve its credibility regardless of the timeline," most likely in July, chief economist Naohiko Baba said in a note published on March 20.